Reduce, Defer, Eliminate – Taxes on a Large Sale

It seems like everyone has a cousin who knows a guy that used a “secret” loophole to avoid paying a bunch of tax. I always say the same thing when someone brings that up: “Oh really? Well, then, you should probably go hire that guy!”

I hate it when professionals try to pull the wool over the eyes of clients by making them think these things are super secret or complicated or a fancy loophole. I like simple; it’s kind of my thing. Oftentimes, the application or implementation of some of these ideas can be complex, but the theories behind them are very straightforward. Understanding the theories can help you discuss and decide intelligently. So, here is my Business is Simple guide to avoiding tax on business sales or other large asset sales.

The first part of this theory is to understand the underlying law or principle. That law is this:

 As you increase the amount of tax deferred, you also increase the amount of control you have to give up to do it.

That is the trade off. It cannot be avoided. The tax code is designed to prevent you from having your cake and eating it, too. It is true for every loophole and trick you have ever heard of. That being said, the methods you can use, in order of usefulness, are Reduce, Defer, and Eliminate.

 Reduce

There are two things you can reduce: Gain or Rate. Reducing the gain means, obviously, you reduce the amount you stand to earn from the sale. Reducing the rate means that you pay a lower tax rate. For example, if you have a capital gain instead of ordinary income you would pay a lower tax rate. Reduction is not something that you can do easily. Usually everything that would qualify as a reduction has already been taken into account. The type of sale is usually set ahead of time. That is why reduction is kind of the low hanging fruit. If you can find something that was forgotten, great! And since it has the lowest chance of changing anything, reduction strategies usually do not require very much loss of control.

 

Reducing Gain

Your gain is what you are paying tax on. It is what you are selling the thing for minus what you paid for it (basis). So, the first step is to see how we reduce the gain. We can reduce it by reducing the sale price. Probably not a good tactic. Which means you have to increase your basis. Did you put money into the business or into the property at some point? Did you have losses on the business or property in the past you didn’t deduct? These increase your basis. Did you inherit the property or business? Did the property get a step up when you did? A “step up in basis” is what happens when you inherit something. Your basis becomes the fair market value on the date of death. None of these things apply? Next item.

 

Reducing Rate

This applies mostly to business sales. Businesses have two types of sales, asset and stock. In an asset sale a business sells the assets of the business (you would still own the entity you had beforehand, but as an empty shell). In a stock sale, you sell the shares of the corporation that owns the business assets. Why do we care? If you sell the assets, most of the gain you have will be ordinary income with tax rates up to 39.6%. If you sell the shares you have a capital gain where tax rates are only around 20%. That is a great trick. But most buyers of businesses want to buy assets, not shares. So, negotiate. If you do have an asset sale, you get to allocate the purchase price amongst the assets you are selling. So, you want to sell the hard assets (machinery, autos, equipment) for as high as you can (these are capital gain) and you want the non-compete or goodwill (ordinary income rates) to be as low as possible. Don’t screw the deal over this, but understand this can have a huge impact.

That concludes Part One of the guide. Look for Part Two where we discuss strategies to Defer taxes.

 

If these strategies are interesting, or you think you might need additional help, please go to the contact page. I would love to work with you!

Big shout out to Jason Rehmus and http://sweatingcommas.com/ for all his help in making this readable. I would be unintelligible if he wasn’t around. 

“Pick Two”

There is a great diagram out there. I have seen it in the context of designers, saying that clients can have their project with two of three characteristics: fast, cheap, or good.

I feel there is definitely some of this in the business world as well, but that those descriptors aren’t quite right. So, I thought it would be fun to make an Accountant’s Venn Diagram.

 

You can have it Cheap.
You don’t pay much. You want to pay over time (or next week). You want to discuss all the forms, time sheets, and steps involved to determine exactly how a fee was generated. You want to discuss or negotiate every bill that you get. The check is “in the mail.” You assume that staff is free and office space is donated.

You can be Absent.
You are disorganized. You have a business but have no idea what an income statement is. Forget about knowing what assets and liabilities are. You use a shoebox for anything other than storing shoes. Your record keeping is that you have “almost all” of your receipts in this box. You don’t want to (or can’t) answer questions or organize anything. You can’t return a phone call or an email in less than four days.

You can be Informed.
You have very specific ideas about how your books/tax returns/project should look. You want to understand every single option, method, and choice and the pros and cons of each. You want concrete answers to amorphous ideas. You ask for the FASB or Revenue Ruling citation. You want all the details on a strategy, and weekly updates, forever.
Having all three of these things is impossible. But you can have any two of them. Each pair creates a very different type of relationship between you and I. Let’s look at how those look, so you can know what you want or need.

Cheap & Absent
Drop your stuff off, let me at it. I promise I’ll handle it. But you’re putting yourself in my hands and you need to trust me. This is really easy and requires almost no work on your part, but you better have trust in your CPA.

Informed & Cheap
This is a teaching relationship. You will have to keep bringing things up, but I will re-explain alternative minimum tax every year for you. Most of the relationship management (and oftentimes the work) falls on you. Most of the knowledge and teaching falls on me. I coach you, but I don’t do the work for you. Great for the DIYers, but be prepared for longer lead times and to crunch some numbers yourself.

Absent & Informed
I’ll be honest. This relationship is a TON of work for me to manage. Constantly chasing you down to give you the details you asked for can be exasperating. I don’t mind doing it. I really don’t! But if you want to demand that much knowledge from me and that little work on your part, be prepared to pay. This is the classic “for $400 an hour, I’ll do whatever work you want”.
As much as this may sound like a complaint, it isn’t. There is a place for all these types of clients and relationships in a business. As long as you and I understand the parameters, we will get along great! But if you expect to have the “trifecta” I can promise you will be disappointed.

 

 

 

 

 

 

Turning Pro – Review

I have read two of Stephen Pressfield’s books now and I have really enjoyed both of them. “Turning Pro” is a fantastic book, full of short and to the point chapters. Not even chapters, really. More like ideas. I found it even more compelling that “Do the Work”.

The central idea is that there are two types of people: amateurs and pros. The difference between the two isn’t what you might think it is.

Amateurs don’t pursue the things they want. They say they will, as soon as they can get free from their distractions. They then proceed to create as many distractions as possible. They live in a tortured mindset of always wanting something and not being able to get themselves to get there. Bhuddists might say that they are unenlightened, or spend most of their time not on “the Path”. We all know these people. In fact, we all were/are one. In short, they are phoning it in.

Professionals know what they want, know what it takes to get what they want, and suit up, show up and do the work. This does not mean that they are always happy, or pursuing their passion, or can make things happen that are impossible, or “think and grow rich.

I really struggle to explain the difference between the amateur and the professional. Pressfield wrote in such an emotionally vivid way, that it seems as if he never really explains the difference. He just tells stories, mostly about himself, until you grok the idea. I can’t figure out how to explain that. It really is an experience you have to just have.

Professionals don’t have all the answers and are not necessarily living a dream. But they find a sort of “zen” center in knowing they are pursuing something they enjoy and are good at, and they take comfort in knowing they are making progress towards something.

It is tough to describe in just a few short sentences, but the best example from the book is the Marine and his two salaries. His financial salary might be low, but he also has a psychological salary. The comfort and feeling of knowing that he belongs to something, that his calling has honor, and that no one can take that away.

If you feel like you aren’t living up to your potential, or that you could do even more, I encourage you to check out this book. It will definitely be worth your time.

 

 

The Way of the Shepherd – Review

I read “The Way of the Shepherdimages” at the urging of the owner of my company and discovered leading and managing are two very different things. If you are trained as a manager, and that is your comfort zone, then leading is going to be a significant challenge. This book, written as a fun parable, really helped me change the lens through which I look at the role of a leader versus that of a manager. It can be a difficult shift to make. What I have discovered is that leadership is equally easier and harder than managing.

Managing is about command and control. It’s about organizing a slew of projects and priorities and the vast swath of actions and tasks that need to be done to accomplish those projects. It’s about making sure that when A is relying on B and B is relying on C and C falls down, there is a way to keep the machine going. It can be an arduous task.

When trying to lead, it is easy to just expand the scope of the management operations. Management involves tracking tasks and projects. But trying to control the activities of everyone in a decent sized organization is impossible. Trying to manage the activities of professional staff is even more impossible. People are, well, people. They are not machines. They are unpredictable; sometimes they accomplish more than you expect and other times they fall far short of expectations. If you have a project sheet and task list for that person, you will pull your hair out trying to keep up. Their progress is their own, all you can do is try to guide it and protect them.

What I have learned is that leadership is just an entirely different way of doing things. Almost none of the tools that you use as a manager are useful in the leadership role. This book did a great job of laying out some simple ideas to get you started on the path to leadership. It certainly doesn’t have all the answers. It won’t cover every situation that might arise. But for someone like me who has seen the world through the manager lens for so long, it was the perfect short, sweet, and simple shake up that I needed to look at things totally differently.

The book really will take two hours to read. If you have people who report to you at ALL, you need to take a look at this book.

Thinking…

I have a couple random thoughts that I have been thinking about. None of them are large enough to be an entire post, so I thought I would do a “what I learned” post.

Thinking is hard work. You don’t realize it, but it is. And when the questions get bigger, it becomes even more work. But it is a very “hard to manage” work. If you had lots of tasks to accomplish, you could make a list, buckle down, and crank things out. But really big decisions permeate everything you do. Your brain doesn’t stop processing them because you’ve left the office. It doesn’t start processing because you have set aside a few hours to brainstorm. The thinking happens when it can, and there really isn’t much you can do about it.

Speaking of thinking, I heard an interesting idea the other day. My buddy, Matt—who has forgotten more about the markets and trading then I will ever likely know—and I were talking about the Fed, Treasury debt, and quantitative easing. We arrived at several conclusions. First, the financial markets are rigged against the little guys. It is sad, but true. It becomes critically important, if you are not a wealthy investor or institution, to look at how you hedge your risks.

The second thing we talked about what his idea to solve the debt crisis. It goes something like this:

The Fed is printing money to buy US Treasury debt. The Fed currently owns a significant chunk of the US government debt and is buying more each month. What would happen if the Treasury defaulted on just the debt that the Fed owned? You would instantly solve both the problems that worry most people: that the Fed’s balance sheet is getting too big and that the US government has too much debt. But with the stroke of a pen you could wipe out both of those things. Or if not wipe out, put a large dent into.

It makes you think about the money supply and how esoteric the whole thing is. Look for more on this idea later.

 

 

 

I Learned QuickBooks might not suck!

If you know me, you know that I dislike QuickBooks. For a variety of reasons.

What I learned this week is that I might be wrong. I’ve always known that I can be wrong, I’m wrong all the time. But I might be wrong about QuickBooks.

The new version of their online accounting software has been completely redesigned and the “test drive” I took was very cool.

It seems to me that QuickBooks just shifted their business to being an “eco-system” rather than a piece of software you use. This is a brilliant move on their part and all those other online software programs that I used to recommend should be scared, very scared. A couple high points, just from the few minutes I spent playing around with it:

-Mobile devices usage is awesome. It lets you fill spare moments with doing a little accounting work, instead of being idle. All those little moments add up to not much focused accounting work needing to be done, is my guess. A brilliant strategy and very reflective of the way people use their devices today.

 

-Linking up bank and credit card accounts in the background lets the computer gather the data for you to process. QuickBooks has had something like this for a while already, but it seems much more streamlined and easier to alter, making it is easier to start and stop that work, instead of having to find hours at a time to get accounting done.

 

-The “overdue” and “needs attention” warnings are awesome. By keeping small business owners (who by and large are accounting novices) focused on a couple issues, they can make meaningful impact on their business without knowing exactly how or why.

 

-Changing from a license billing model to a monthly fee model. This is the best part of the whole thing. Having the data in the cloud, with up to three simultaneous users (in the mid-tier version) eliminates the largest problem we have had with QuickBooks. They have really used all the best of currently available technology to really give the software a 21st century face lift.

 

All in all, I give this a solid thumbs up. I have talked a lot of Sh*t on Quickbooks and Intuit. This is me saying I was wrong, and BRAVO.

Look for more info on this later, as I start developing some guidebooks on how to run company on this software! I think this will be the backbone of how I tell business owners to run their business.

 

This week I learned about a clever evaluation tool called “DuPont Analysis“. It is a metric that measures Return on Equity by looking at three factors:

400px-DuPontModelEng.svg

 

-Profitability (Measured by profit margin)

-Operations (Measured by asset turnover)

-Leverage (Measured by equity multiplier)

I thought I would share this because it was intriguing  how all the various ideas of business can be rolled in to one metric. Most small businesses won’t find this kind of analysis, in a technical sense, useful. Even if you have QuickBooks and have good records, sitting down to calculate this has little value.

However, it is worth noting, that no matter how small your business the idea still holds valid. Your business generates value in several ways:

Profit Margin: Is your core business model sound? Does it make sense? Am I generating sufficient profit on my revenue?

Operations: Am I using my assets (people, machines, inventory, etc) efficiently? A business with a sound model can still be run poorly from an operations stand point.

Leverage: Am I using my money wisely? In large companies this means “Do I have the proper capital structure for our business?”. But in small businesses it represents a much easier idea: “Am I using my money wisely?” Do I spend too much? Am I reinvesting in my business? Am I reinvesting in smart ways?

 

Anyways, just another example of my central thesis that: just because your business is small, doesn’t mean it can’t and shouldn’t be looked at in complete and sophisticated ways. And that can be surprisingly simple to do!

 

 

http://cpaandrew.com/2013/10/23/745/

Current Account Balances are Simple!

I learned something important this week. Actually, I learned two things.

The first is that all those terms you hear on the news (and ignore) aren’t as complicated as you think. I don’t know where we got the idea that only experts and academics who do nothing but study can understand global trends in economics. Most people I know could follow a simple story about the first decade of the 20th century. I just wonder why no one explains it simply.

The second thing I learned relates to trade balances, current accounts, imports & exports and deflation. All those words that you usually ignore.

For most of the first decade of the 21st century, we have had low unemployment. Usually when unemployment is low for extended periods, inflation starts to become an issue. As employers have to pay more for labor (because there is a shortage) employees have higher pay. Employees with higher pay tend to increase their own spending, which bids up prices for goods, causing inflation.

But curiously, the inflation rate didn’t move that much in this time period. Sure, we had inflation, but it wasn’t out of control. Yet unemployment remained low. How did this happen?

The simple answer is the current account balance was negative the entire time. We “exported” our inflation. As developing countries, noticeably China and India, became more plugged into the global economy, we purchased more and more items more and more cheaply. This “deflation” offset the inflation that low unemployment was causing. The end result is that we landed somewhere in the middle of the two.

Trade isn’t a zero sum game! Those countries needed growth, we needed deflation, so they traded their deflation for our inflation and everyone ended up happy. Well, maybe not happy, but you get the idea.

Why should you care? Now that you understand the mechanisms, you can make sense of what people are telling you. You can now tell people who complain, “China is going to buy America because we owe them so much money!” that if they really understood trade balances, they’d know those countires needed our growth as much as we needed their savings.

You can also know that, if this trading starts to taper off (China’s growth starts to decrease, for example) there is a good chance our deflation will slow down. If deflation slows down, the opposite happens and we get inflation. With inflation, we get people back to work!

See? it isn’t that hard.

Selling a Business

This week I learned a lot of business are being sold right now. At least, there are in my world. This is not a comment on the business cycle as a whole, just an observation on what I see. It does make sense though, based on the demographics of the world. More and more Baby Boomers are looking to retire and trying to extract some value from their business is an important part of that puzzle.images (1)The real thing that I have learned, that is interesting, is that there is a LOT of variation in the market for buying and selling very small businesses. If you want to sell a company worth $50MM or more, there are lots of brokers, investment advisors, and consultants that can help. The market is pretty clean and professional. If you have a business doing $500k to a couple million a year, then it is quite likely that you are being under-served. Or worse yet, leaving money on the table.

The range of deals and brokers is vast. I have seen lots of brokers that are quite simply idiots (see my tweet about New Web Sights) and I have seen more that are just crooks.  I know, and use, some that are worth their weight in gold. But they are the exception, not the rule. I have had clients get such fantastic deals I almost feel bad for taking advantage of the seller. I have seen clients walk away from deals that were the best they were ever going to get, and accept deals that were way too low.

Here are a couple things I have learned from helping clients buy and sell businesses ( buying a few myself):1. Signing an exclusive contract with a big commission is not a mandatory part of the process.
2. Having someone who can take the emotion out of it for you is usually well worth the cost.
3. But don’t be afraid to shop that cost around!
4. Brokers will sell themselves by how much higher value they can get for you because of how they “market” your business. The truth is, their greatest asset is being able to connect you to possible buyers. You either have a great business or you don’t.
5. Get a realistic expectation of what your business is worth. Be prepared to support that value.
6. If you can’t produce numbers and support for how valuable your business is, then expect no value from the sale.
7. You might be pleasantly surprised by how much your business is worth. You might also be shocked at how much less it is worth than you think.
Even if you don’t think you want to sell your business any time soon, knowing what it is worth is critical. If you are planning to sell at any point, knowing this is even more important. So start gaining an understanding of how the process works ahead of time, and don’t get taken for a ride!

Economic Theories are Fun!

What I learned this week:

I am reading Profiting through Monetary Policy and there was a great description of the difference between the Credit Supply theory and the Money Supply theory of economics. In most cases, the Austrian Business Cycle theory (another name for the Credit Supply Theory) has been shown to be flawed in many ways. Regardless, it still is a useful lens to use to look at the more mainstream idea of Money Supply. The short version is this: central banks and governments try to control price levels using the money supply as their tool. They use things like interest rates, asset purchases and sales, and fiscal policy to increase and decrease the supply of money in the economy, thereby attempting to equalize the business cycle.
images
An alternatively well-known version of this involves the Phillips curve, which no one knows by name even though understand the relationship. If unemployment is high, then increasing the overall pace of the economy (GDP), which is inflationary, will tend to decrease unemployment. In other words: you can trade unemployment for inflation. Increasing one (inflation) will decrease the other (unemployment) and vice versa.

The Credit Supply idea says that this manipulation of the money supply is what causes the business cycle (boom and bust) in the first place. The easy supply of credit inflates asset prices as money moves into them, increasing the money supply. When the market then has to match productive capacity realities to the inflated asset supplies, money has to come back out (a crash) in asset prices.

The first decade of the 21st century experienced both low unemployment and relatively low inflation. It could be argued that the only reason all that low unemployment and easy credit did not inflate the economy was that during that time China, India, and other developing countries were “exporting” deflation to us. The costs of goods were falling in conjunction what should have been inflation, because so many millions of workers were finally being plugged into the global economy. But it turned out that we in developed countries are not that much more productive than the new labor coming from developing nations. Therefore, as per Credit Supply theory, we eventually had to value assets on their real value and not nominal value. Prices came crashing down again, and all the additional money into the economy didn’t help much.

Is this a 100% true and accurate representation of what happened? No. Is there a definitive answer to whether the business cycle moves according to Credit Supply or Money Supply? No. But did I learn something new about what may and may not drive the changes in prices we see? YES.

And learning is good!